Do You Need a Market Neutral Fund?

Market neutral funds first started capturing investors' attention a few years ago, in the midst of the great hedge fund love affair. Eager to cash in on the popularity of hedge funds and their apparent ability to manufacture stellar returns out of whole cloth, a slew of hedge fund-like mutual funds -- including market neutral funds -- were brought out.

Indeed, nearly half of the 99 funds classified by Morningstar as long-short equity funds (the general classification that such funds fall into) were introduced between 2008 and 2010.

As the name implies, market neutral funds are designed to produce returns that are uncorrelated to the direction of the overall market -- a trait that's been a particularly easy sell over the past few years.

In attempting to achieve this performance, the manager typically holds a group of stocks he believes will outperform the market, and sells short another group of stocks that he believes will underperform. Doing so, in theory, will produce relatively modest but consistent returns over time, regardless of what direction the stock market is headed.

Apparently, implementing this strategy costs quite a bit, as evidenced by the staggering 2.2 percent expense ratio that the average market neutral fund carries. No matter how smart a manager is, that's a tremendous hurdle to over come year after year.

And as it turns out, the average manager is apparently being tripped up by that hurdle. Since 2006 the average market neutral fund has lost 0.3 percent.

While that return might look nice compared to the S&P 500 index's annual return of -5.8 percent during that same period, the S&P 500 isn't a very appropriate benchmark for these funds. After all, if you're seeking an investment that will allow you to participate in the market's upside while protecting you from the downside, a fund designed to track the stock market is a rather poor choice. The traditional alternative has been a balanced fund, which owns a mix of stocks and bonds.

During that same period, a balanced index fund with a 50 percent allocation to the S&P 500 index and a 50 percent allocation to the Barclays U.S. Aggregate Bond Market index earned 1.3 percent annually, after adjusting for fees of 0.2 percent -- outpacing the average market neutral fund by one percent annually.

That disappointing record is what led the authors of a recent academic article that examined the performance of these funds to conclude that they found "no evidence that hedge fund-like mutual funds in general add any value for investors."

Market neutral funds are shaping up to be yet another marketing gimmick, designed to appeal to investors by seemingly offering the best of both worlds -- protection from market declines and participation in its rallies.

If that's your goal, you're likely to be far better served by ditching a faith in a fund manager's talent in favor of a low-cost balanced index fund.